Thursday, 25 June 2009

Review by Bruce G Charlton done for for Azure magazine - http://azure.org.il . This review was commissioned, but the editor didn't like what I wrote and it was rejected)

Animal Spirits: how human psychology drives the economy, and why it matters for global capitalism by George A Akerlof and Robert J Shiller. Princeton University Press: Princeton, NJ, USA. 2009, pp xiv, 230.

As a human psychologist by profession, I was looking forward to reading a book written by a Nobel prize-winner in economics and a Yale professor in the same field which – according to the subtitle – argued that human psychology was ‘driving’ the economy. In the event, I found this to be an appalling book in almost every respect: basically wrong, irritatingly written, arrogant, and either badly-informed or else deliberately misleading in its coverage of the aspects of human psychology relevant to economic outcomes.

The main argument of the book is that ‘rational’ models of the economy are deficient and need to be supplemented by a consideration of ‘animal spirits’ and stories. Animal spirits (the idea comes from John Maynard Keynes) are postulated to be the reason for economic growth and booms, or recessions or crashes: an excess of animal spirits leading to overconfidence and a ‘bubble’, and a deficiency of animal spirits leading to the economic stuck-ness of situations like the Great Depression in the USA.

The authors regard the rise and fall of these animal spirits as essentially irrational and unpredictable, and their solution is for governments to intervene and damp-down excessive spirits or perk-up sluggish ones. Governments are implicitly presumed, without any evidence to support the assumption, to be able to detect and measure animal spirits, but to be immune from their influence. Governments are also presumed to know how to manipulate these elusive animal spirits, to be able to achieve this, and willing to do so in order to the ‘general public interest’.

I found all this implausible in the extreme. Akerlof and Shiller will be familiar with the economic field of public choice theory, which explains why governments usually fail to behave in the impartial, long-termist and public-spirited ways that they hope governments will behave – yet this large body of (Nobel prizewinning) research is never mentioned, not even to deny it.

The phrase ‘animal spirits’ is repeated with annoying frequency throughout the book, as if by an infant school teacher trying to hammer a few key facts into her charges, however all this reiteration never succeeded in making it clear to me exactly what the phrase means.

The problem is that the concept of animal spirits is so poorly characterized that it cannot, even in principle, be used to answer the numerous economic questions for which it is being touted as a solution. So far as I can tell, animal spirits are not precisely defined, are not objectively detectable, and cannot be measured – except by their supposed effects.

Akerlof and Schiller talk often of the need to add animal spirits to the standard economic models, but it is hard to imagining any rigorous way in which this could be done. Perhaps they envisage some kind of circular reasoning by which animal spirits are a back box concept used to account for the ‘unexplained variance’ in a multivariate analysis? So that, if the economy is doing better than predicted by the models, then this gap between expectations and observations could be attributed to over-confidence due to excess animal spirits, or vice versa?

There is, indeed, precedent for such intellectual sleight-of-hand in economic and psychological analysis – as when unexplained variance in wage differentials between men and women is attributed to ‘prejudice’, or when variation not associated with genetics is attributed to ‘the environment’. But I would count these as examples of bad science – to be avoided rather than emulated.

Another major theme of the book is stories – indeed the book’s argument unashamedly proceeds more by anecdote than by data. According to Akerlof and Shiller, animal spirits are profoundly affected by the stories that people, groups and nations tell-themselves about their past present and future, their meanings and roles. For example, the relatively poor economic performance of African Americans and Native Americans is here substantially attributed to the stories these groups tell themselves. For Akerlof and Shller, stories - like animal spirits - are attributed with unpredictable and wide-ranging properties ; sometimes replicating like germs in an epidemic for reasons that the authors find hard-to comprehend. (In this respect, A&S’s ‘stories’ seem to have very similar properties to Richard Dawkins’ ‘memes’.)

The big problem with the A&S use of stories as explanations is that each specific story used to explain each specific economic phenomenon is unique. So, instead of postulating a testable scientific theory, we are left with a multitude of one-off hypotheses. The causal model a specific story asserts is in practice un-stestable – each different situation would presumably be the result of a different story. For example, if each boom or bust has its own story, then how can we know whether any particular story is correct?

And who decides the motivations of a specific story? Akerlof and Shiller suggest that the Mexian president Lopez Portillo created a bogus economic boom because he ‘lived the story’ of Mexico becoming wealthy due to oil, and the Lopez story led to excessive animal spirits with 100 percent annual inflation, unemployment, corruption and violence . Yet the most obvious explanation is that Lopez ‘lived’ the story because it served his interests, providing him with several years of wealth, status and power.

However, this story is unusual in blaming the government for excessive animal spirits, corruption and short-termism. Since Akerlof and Schiller are advocating a large expansion in the state’s role in the US economy they usually focus on irrational animal spirits in the marketplace. This is rhetorically understandable since A&S advocate that the state should to regulate markets to moderate the unpredictable and excessive oscillations of animal spirits – and this only makes sense if the government is less prone to animal spirits than the market.

But why should the government be immune to irrational animal spirits, corruption and selfish short-termism? Why should not the government instead exploit variations in the economy for their own purposes and to benefit the special interest groups who support them – surely that is what we see all the time? Indeed, what we are observing on a daily basis? - rather than the A&S utopian ideal of state economic regulation based on disinterested wisdom and compassion.

I personally am persuaded that governments were the main culprits behind the current credit crunch. If governments had allowed the international housing bubble to collapse several years ago as soon as the bubble was identified (e.g. in Our global house price index; The Economist. June 3 2004), or if necessary government had taken steps to prick the inflationary bubble, then we would have had a much smaller and manageable recession than the disaster that eventually came after several years more ‘leverage’. But instead – fearing a recession under their administration – all the important governments pulled-out-the-stops to sustain housing price inflation. Even after the crunch, US and UK governments have tried (unsuccessfully) to reinflate the housing bubble – amplifying the damage still further.

The big problem behind this type of behaviour is surely one of governance. Governments probably know what they ‘ought’ to do to benefit the economy, but they seldom do it; and instead they often do things which they know will be very likely to damage the economy. Economist Milton Freidman reported that in private conversation US President Richard Nixon admitted that he knew exactly what kind of havoc would be wrought by his policy to control gasoline prices (shortages, vast queues, gas station closures etc.) – but Nixon went ahead anyway for reasons of short term political expedience.

Democratic governments seem to find it almost impossible to enact policies that will probably have benefits for most of the people over the long term, when these policies will also enact significant costs over the immediate short term. To allow the housing bubble spontaneously to ‘pop’ in 2004, or to stick a pin in it if it didn’t burst, would undoubtedly have been wise; but governments seldom behave wisely when to do so exerts immediate costs. The problem is made worse when such ‘wise’ policies harm the specific interest groups upon whose votes and funding governments depend.

The reason why politicians ignore the long term was given by Keynes when he quipped that ‘in the long run, we are all dead’. Akerlof and Shiller use other Keynsian ideas to forcefully advocate increasing the state’s regulatory role in the economy, but in the absence of any solution to these fundamental ‘public choice’ problems, this will surely do far more harm than good because politicians live by Keynes’ principle of concentrating on the short term.

In sum, Akerlof and Shiller have a one-eyed focus on the problems of markets and their tendency towards irrationality, corruption and short-termism; while simply ignoring the mirror image problems of governments. But while market competition and cycles of ‘creative destruction’ put some kind of limit on market failures – the democratic process exerts a far weaker and much slower discipline on the failures of government. And incumbent governments have far too many possibilities of ‘buying votes’ by creating dependent client groups (as it happening with terrifying rapidity in the USA at present). If markets are bad, and they often are; then current forms of democratic government are even worse.

But for me the major fault of this book is that it is advocating an un-scientific approach, consisting of a collection of ad hoc stories to explain various phenomena, held together by the large-scale, vague and probably circular concept of animal spirits. For me this looks like a retreat from science into dogmatic assertion – admittedly assertion backed-up by the undoubted intellectual brilliance of the authors – but by little more than this. In particular, this book which purports to be about how human psychology drives the economy actually has little or nothing to do with what I would recognize as the scientific field of human psychology.

The best validated psychological concept in psychology is general intelligence, usually known as IQ and highly correlated with standardized tests results such as the American SATs, reading comprehension, and many other cognitive attributes. IQ has numerous economic implications, since both for individuals and groups IQ is predictive of salary and occupation. But Akerlof and Schiller ignore the role of IQ.

For example, they have a chapter on the question of “Why is there special poverty among minorities?’ in which they generate an unique ad hoc story to explain the phenomena. Yet there is essentially no mysterious ‘special poverty’ among minorities because observed economic (and other behavioural) differentials are substantially explained by the results of standardized testing (or estimated general intelligence). US minorities that perform better than average on standardized testing (e.g. East Asians, Ashkenazi Jews, Brahmin caste Indians) also have economic performance above average; and vice versa.

The scientific basis of Animal Spirits is therefore weak, and in this respect it is much inferior to another new book on human psychology and the economy: Geoffrey Miller’s Spent: sex, evolution and consumer behaviour – which is chock full of up-to-date psychological references and brilliant insights from one of the greatest of living human evolutionary theorists.